Hey There Income Hunter,

With ultra-low borrowing costs in the rearview mirror, we are beginning to see stress building in the credit market. 

This is the most important signpost to watch in 2023.

This week, Bloomberg reported that distressed debt in the US grew more than 300% year-over-year. Obviously, the fastest pace of Fed tightening in 50 years is responsible for the dramatic shift.

This has the banks on high alert as they are now tightening their lending standards, which will make it more difficult for borrowers to refinance their debt at favorable rates. 

Today, we will take a look at how close this is to becoming a serious problem for the markets.

Debt Pileup 

Leveraged loans have seen the “greatest buildup of excesses or lower-quality credit,” according to UBS. And default rates could rise to 9% next year if the Fed stays on its aggressive monetary policy path.

It hasn’t been that high since the financial crisis of 2008.

The pile-on lately has been about $40 billion of buyout debt between Twitter and auto parts maker Tenneco Inc. 

Danger signs built up during the Fed easing cycle as lenders with excess cash on hand lessened their protections against defaults and became more exposed to risks.

Now companies are more leveraged than they were during the global financial crisis. 

The Big Short Revisited

Remember the collateralized debt obligations or CDOs that were popular during the housing crisis in 2008? Well, the big risk today is in the collateralized loan obligation market (CLOs).

CLOs pool leveraged loans and package them to sell to customers at advantageous yields … The problem, just like in 2008, is the lower-rated bonds defaulting on payments.

Matthew Rees, head of global bond strategies at Legal & General Investment Management, says he’s concerned about higher defaults in lower-tier portions of CLOs.

Daniel Miller, Chief Credit Officer at Capra Ibex Advisors, is also worried about covenants, particularly those that circumvent the priority of creditors.

“They are potential ticking time bombs sitting in the documentation,” he said.

It’s Subprime Time 

Another big issue in 2008 was the defaults on subprime mortgages lent to less credible borrowers. 

Well, today lenders made the same mistake with auto loans as prices on used cars skyrocketed during 2021.

However, as soon as the Fed tightening policy took hold, prices plunged and, as you can see below, interest rates soared … 

Borrowers are in a negative equity situation now and many will just hand the keys back to the banks.

Bring It Home 

History doesn’t always repeat, but it certainly does rhyme.

After the dot.com bust in 2000, the Fed dropped interest rates by more than 5% and overstimulated the economy, which led to the housing crisis.

Fast-forward to the covid pandemic when the Fed overstimulated and then let inflation rise much further than it should have. 

Banks took advantage of the excess cash to maximize profits but are now stuck with risky positions as the Fed raises rates at the fastest pace in history. 

Keep an eye on lower rated debt ETFs like HYG and JNK to monitor stress in the market and the potential for the Fed to pivot back to an easing policy.

I want to wish everyone the happiest of New Years’ and thank you for engaging with Option Pit in 2022!

Live and Trade With Passion My Friend,

Griff